Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at the Morningstar Investment Conference, and I'm happy to be joined today by Bill Bernstein. He's the author of several great investment books, including The Investor's Manifesto and The Four Pillars of Investing.

Bill, thank you so much for being here.

William Bernstein: It's a pleasure.

Benz: Bill, I would like to focus on fixed income today. You are an expert on asset allocation, and I think that everywhere you go right now, you hear gloomy prognostications about the outlook for fixed income. I'm wondering if you can talk about how investors should approach that allocation right now given the prospective headwinds that could face fixed-income investors in the decades ahead?

Bernstein: Well, first of all, there's a lot of concern about fixed income as you've already alluded to. People are worried that the returns are going to be low, and I think that's almost a mathematical certainty. If yields stay where they are you're going to get a very low yield; that's the best-case scenario. If yields rise from here, then you are going to achieve probably negative returns with any duration at all. Yields on Treasuries have fallen over the past 30 years from the midteens down to 0%, 1%, or 2%; they can't fall another 14% fromhere. And I think unfortunately people are expecting that to happen. So you have to back up and ask yourself, what is the purpose of your fixed-income assets. Well, they're for emergency needs. They're to buy stocks when they are cheap, so you can sleep at night. And they're to buy that corner lot from your impecunious neighbor who suddenly has a need of cash. It's not to achieve a return.

And so with that in mind you want your safe assets to be as safe as you can, and you should be investing in four things, which are Treasuries at the short end, and certificates of deposit and money markets, and then a clothes pin for your nose to be able to deal with those very low yields that you're going to be getting.

Benz: Bill, one conundrum that I know a lot of our readers have wrestled with is they know they are approaching retirement, and I guess I would ask you, if I were to come in to your office today and say, "I'm a couple of years away from retirement and most of my portfolio is in equities," how would you suggest that I approach the portfolio, and how would you suggest that I derisk that portfolio?

Bernstein: Well, it depends upon what your needs are. Let's take the best-case scenario; let's say you're a very wealthy person with very low needs. Let's say you've got a $5 million portfolio, and you only need $50,000 a year to live on, so you have a 1% drawdown rate. Well, stocks yield 2%, and in the worst-case scenario that something had happened, say what happened from 1929 to 1932, although the stock index went down by 90%, the dividend dollar output, the dividend throughput, only fell by 50%. So you're still safe. So you could invest if you wanted to in 100% stocks.

Benz: That's not most people feel unfortunately.

Bernstein: But it gives you a way of thinking about it.

Benz: Right.

Bernstein: Now, let's say that instead of a $5 million portfolio, you have $1 million portfolio. Now you cover your needs by a factor of 20. Really, in that situation, if you want to retire at that point, there's only one thing you should be doing, and that's to take that money and probably either buy a Treasury Inflation-Protected Securities ladder and some longevity insurance on top of it, or you could just throw it all into three or four immediate fixed annuities and pretty much cover almost all of your living expenses on that. You can't take any risk.

Now in the worst-case scenario, you don't even have that. You've only got $250,000, and in that case, I would look the person straight in the eye, and I would say, "You are not retiring in two or three years; you are working until you can acquire 10, 15, or 20 years' worth of living expenses. And that's going to mean a combination not only of working longer, but you are also going to have to decrease your consumption needs, as well."

Benz: You mentioned longevity insurance. You also mentioned fixed annuities. What about the current interest-rate environment, especially for fixed immediate annuities? I think, it's really made the payouts from those annuities right now quite low. Would you suggest investors wait before purchasing annuities or ladder annuities. What's strategy there?

Bernstein: Yeah. I certainly wouldn't suggest people go out right now and throw all their money into an immediate fixed annuity. I think, say, a 65-year-old or a 70-year-old person should average into those annuities over a period of five or 10 years. But there's another strategy. It is a wonderful strategy for the average person, which is to draw down their living expenses out of their retirement accounts, so they can take Social Security at age 70. That is the world's best annuity.

Benz: Hold off on taking that Social Security.

Bernstein: Yes, and effectively what you are doing is buying that annuity by paying your living expenses between the ages of say 62 or 66 and age 70, and that's, by a mile, the most effective annuity that anyone can purchase.

Benz: It's inflation-adjusted, which is something you don't get everywhere.

Bernstein: Correct. Yes.

Benz: The last question I want to cover with you, Bill, is capitalization-weighted indexing or bond indexing. I think that investors wrestle with that question. Do I want to index the bond component of my portfolio, and thereby cast my lot with the most profligate borrowers? What's your take on that question, and how should investors go about constructing their fixed-income portfolios?

Bernstein: I think that's right. I'm not a big fan of bond-fund investing for exactly that reason.

Benz: So no bond funds period?

Bernstein: I woundn't say that. I mean I have no problem with a corporate bond fund, for example, a high-grade corporate bond fund for a small part of the portfolio as long as you realize that that's not really in the riskless part of your portfolio; that's a risky part of the portfolio. I think that, again, the purpose of your bonds is as a riskless ballast for all the purposes that I gave several minutes ago. And I think that the bulk of your fixed-income holdings shouldn't be bond index funds. I think, they should be in the three safe assets, plus the clothes pin that I mentioned before.

Benz: So the three safe assets were cash, short-term Treasuries, and CDs?